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Low Rates/Expansionary Policies = Chicken v. Egg

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If you think record-low interest rates are the result of years of expansionary monetary policies, think again.

According to some economists, it’s the other way around: Central bankers are offering up expansionary monetary policies because long-term natural rates are low and declining.

Downward pressure on the cost of money makes it increasingly difficult for central bankers to calibrate the right monetary policy, and doubt that central bankers have sufficient arrows in their quivers is widespread—even in government finance agencies. A recent paper by John Williams, president and CEO of the San Francisco Federal Reserve, openly discusses how to adjust the tools of monetary policy to a world in which the natural rate of interest has declined to historically low levels.

A study published in July by the Bank of England explains why the so-called “natural,” or “neutral,” interest rate—the rate that will neither spark inflation nor dampen GDP growth—has declined over time. Persistent secular trends, including demographic shifts, rising income inequality and an emerging- markets savings glut (more foreign currency held in emerging countries), have put downward pressure on real rates at a time when there is less demand for capital goods, and have shaved global rates by an estimated 300 basis points. “This suggests the global neutral rate, which acts as an anchor for individual countries’ equilibrium rates in the longterm, will remain low, perhaps around 1%,” the BoE study concludes.

In future recessions, therefore, central bankers will have to push interest rates even deeper into negative territory to remain effective. “Conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a bound on how low interest rates can go,” according to Williams.

He believes the Fed should replace the current inflation target with flexible price-level or nominal GDP targeting, which means shifting the focus from inflation alone to a combination of inflation and real GDP growth. Under such a regime, the bank would not, for example, raise rates when inflation rises if forecasts suggest a larger fall in GDP, from, say, an unexpected surge in input costs.

Some economists believe monetary policy can still be sufficient, if central banks are willing to blow through the “zero lower bound.” When interest rates fall to zero or below, lenders must pay borrowers, and often therefore prefer to hoard. That limits the capacity of the interest rate alone to stimulate growth—unless there’s a penalty for holding on to the money.

Miles Kimball, a professor of economics at University of Colorado, Boulder, suggests a penalty to keep money circulating: Private bank deposits with the central bank should be taxed—he calls it a paper currency deposit fee—to discourage hoarding. “Today if you deposit $100 we will credit your account with 100 electronic dollars,” Kimball explains. “But if you deposit 100 paper dollars three months from now, you might expect that we would credit you with $99.75; and if you come a year from now, we will credit with $99—this is in the hypothesis of minus 1% paper currency interest rate.”

Kimball has presented his idea to several central banks, including those of Canada, England and Japan as well as the Fed, in an academic roadshow. More presentations are scheduled for the fall, including one at the European Central Bank in November. Giving central banks the ability to drive interest rates even lower would give monetary policy its power back, he says. However, governments must act to increase growth because the natural interest rate is determined by factors that central banks cannot control.